Why do some companies鈥 profit margins exceed their competitors?聽How does one company garner a competitive advantage against its peers?聽The answers to these questions may be found聽in value chain analysis.聽

Value chain analysis is the process of looking at the activities that go into changing the inputs for a product or service into an output that is valued by the customer.聽Companies conduct value-chain analysis by looking at every production step required to create a product and identifying ways to increase the efficiency of the chain.

Porter's Value Chain Analysis

Back in 1985, Michael Porter, a Harvard Business School professor, introduced a basic value chain model in his book The Competitive Advantage: Creating and Sustaining Superior Performance.聽He identified several key steps common among all value chain analyses聽and determined that there are primary and supporting activities that when performed at the most optimal levels will create value for their customers,聽such that the value offered to the customer exceeds the cost of creating that value, resulting in higher profit.聽Porter鈥檚 framework groups activities into primary and support categories.锘柯

The primary activities focus on taking the inputs, converting them into outputs, and delivering the output to the customer.聽The support activities play an auxiliary role in primary activities.聽When a company is efficient in combining these activities to provide a superior product or service, then the customer is willing to pay more for the product than the cost to make and deliver the product which results in a higher profit margin.聽

Let鈥檚 work through an example of an asset management firm.聽The goal of the client is to achieve the highest possible return on investment within the guidelines and restrictions set forth by the client.聽

The firm鈥檚 primary activities include:

  • Investment team (portfolio managers, analysts) 鈥撀爐asked with making the investment decisions.
  • Operations and traders聽鈥撀爐asked with ensuring the investments are in line with the guidelines set forth by the client, and the trades are at the best execution price.
  • Marketing and sales聽鈥撀爎esponsible for procuring clients.
  • Service (client relationship management)聽鈥撀爎esponsible for providing聽all the touch points to the client.

Support activities include:

  • Technology聽鈥撀燿esigns聽a trading and client module that is efficient and effectively allows the team to provide the highest level of service and make the best investment decisions.
  • Human Resources 鈥 finds and retains the highest level of talent at the firm.
  • Infrastructure 鈥撀爄ncludes the lawyers and risk managers whose oversight is crucial to ensuring the client鈥檚 guidelines are followed, the investment risk is controlled, and the firm is operating within the regulations established by the SEC.聽

How to Improve the Value Chain

When a firm takes into account its value chain, it needs to consider its value proposition, or what sets it apart from its competitors.聽Value chain analysis is designed to improve profits by creating a product or service that is so superior that customers are willing to pay more than the cost to develop it.聽

But improving a value chain for the sake of improvement should not be the end goal.聽Instead, a company should decide why it wants to improve its value chain in the context of its competitive advantage to differentiate itself among聽its peers.

Two common competitive advantage strategies include low cost provider or specialization/differentiation of product or service.聽

  • Low-cost provider聽鈥撀爒alue chain analysis focuses on costs and how a company can reduce those costs.聽
  • Specialization聽鈥撀爒alue chain analysis focuses on the activities that create a unique product or differentiation in service.

Let鈥檚 go back to our asset management example.聽After the value chain is identified, then the asset manager should determine its competitive advantage and pursue activities that go towards reaching those goals.聽In this case, the asset manager wants to pursue a strategy of differentiation by delivering a product that has steady, top quartile returns over three years.聽

Based on the drivers of uniqueness Porter identified, the firm needs to focus on its policies and decisions and聽learn聽to differentiate itself in terms of performance.聽By focusing on these drivers, the two primary activities of the investment team, operations, and the traders, along with all the identified support activities, can聽manage a product that achieves its differentiated competitive advantage.聽

The Bottom Line

Value chain analysis is a handy management tool which identifies the activities that go into creating a superior product or service that is highly valued by customers.聽The outcome of creating this highly valued product is that customers are willing to pay a premium, which exceeds its costs, thereby delivering higher profit.

The usefulness of this model created by Michael Porter is mostly seen in its ability to breakdown work product into various activity groups to strategically focus the management on what are beneficial activities, and what creates value.聽It also concentrates a company to determine a vision utilizing a competitive advantage strategy which will drive future products and services.聽Supporting activities are further validated in the process, creating an understanding that these sometimes overlooked activities are integral to the value chain and value proposition for a company.